Monday, February 25, 2013

Cost Reduction and Pricing


Reduce cost and increase profitability is the key metric being learnt and applied blindly for any success of a product. Pricing of the product is often ignored and its being derived based upon the ROI expected from the investments which doubles the percentage of profit to be calculated over the cost of production. In my previous couple of articles Balanced Score Card into Budgets, I have marked very clearly that combination and clear understanding of the tools will redesign cost and improve efficiency for the company. In my research I have found that Price and Cost needs to align with the objectives of the Balanced Score Card. Now my readers might come up with a deep level of curiosity that why I am writing so many articles about Balanced Score card.

The answerer is simple we don’t understand and adopt the easy process of designing business strategy aligning with the cost through Balanced Score card.  After the debacle of 2008 consumption and price of products has been the key factor for every organization and every product. Price decides the fate of the organization but I find this is pricing is being calculated at the least consideration and much of the focus applies on cost of production and finally deriving the profit percentage to arrive at the price of the product. It’s the combination of cost and price that helps an organization to achieve its Balance Score Card. In this article I am starting the new dimension of gaps and flaws while designing cost and cost strategy.

Pricing of a product plays a vital role for deciding the future of a product, organization and all the resources deployed to gain the profitability. Financial management fails to identify the place where expenses needs to replaced and not reduce only. Cost Accountants are equipped to identify the gaps and replace the cost by cutting it from other cost centers. The difference between Price and cost of production is termed as profit. While I find profit is way higher than the real profit. Real profit might turn out to be the key factor while designing the product pricing.  

Cost reduction will lead to profitability is a wrong thinking since it has been found in research across the globe that cost reduction leads to destruction of values and growth of an market, organization and product too. Shifting and right allocation of cost which leads to activity based costing can only be applied when one has detail understanding of the cost drivers and link between shifting of cost between the cost drivers so that balance is not broken at any cost centre. Well it easier said than done. Higher sales will result to higher profit every time is a false concept since higher sales might recover the part of fixed cost. Pricing of a product is a mixture of marketing, cost accounting, business strategy, engineering and economics. Hence cost accountants are the ideal labour who are for having an in depth knowledge of the all these to implement and design the pricing.

Inflation is the biggest problem while designing prices of a product. I find it it’s the biggest problem of earning profitability. One will come with a reply that rising cost needs to be absorbed by increasing the price to maintain the profitability. Well this is the biggest place where a product finds its death. While designing the cash flow we design the structure by increasing cost of production. Well we also increase prices to increase the EPS followed with an increase in P/E ratio. Well the flaw within the system is that prices and cost needs to have a wide gap where despite of increase in cost backed by inflation the real profit remains within the expected lines of the company.

Moreover, fixed cost of a product declines over the years followed with one time innovation cost and depreciating cost of production this is the real profit which is calculated.  But this cost is being kept fixed when we derive pricing of a product and we calculate inflation hikes on the old cost of production. Product pricing should be designed in such a way that despite of increase in cost of production the pricing remains the same. This might sound like a stupid but we never calculate the real profit which remains neglected.

While designing the cost reduction process we fail in developing the benchmark for such reduction. Benchmark for reduction of cost is the vital factor which will guide the way of arriving at the proper price. Benchmarking for cost reduction is developed in two ways:

1) Internal Benchmarking: This is developed on the various departments within an organization and its specific policies. Difference in cost is bound to come since difference between plant layout, automation, and employee training and management practices and

2) External Benchmarking: Based upon best standards of the Industry. Financial management blindly reduces cost and increase prices affecting value to derive the EPS over the years. Fixed cost is often miss-calculated and while designing flexible budgets fixed cost component is being kept constant where the same gets reduced backed by depreciation. Real profit always remains high for every company.

It’s the high ambition of earning double or triple profit that increases the cost of production which itself is a methods of earning revenue.

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